Competition And Openness To Trade Reduce Inflation

Inflation tends to be higher the higher the level of monopoly power in the economy and the more closed it is to international trade. These are among the conclusions of new research by Professor Robert Barro and Dr Silvana Tenreyro, published in the April 2006 Economic Journal.

According to their analysis, shifts in the extent of competition, which affect mark-up ratios, are possible sources of aggregate business fluctuations. During booms, mark-up ratios go down and the economy operates more efficiently, leading to higher (measured) productivity levels.

Mark-up ratios – measures of the inefficiency associated with monopoly power in the economy – are defined in terms of the ratios of prices of goods or inputs sold under conditions of monopoly power to prices of goods or inputs sold under competitive conditions. In particular, mark-ups correspond to the prices of differentiated intermediate inputs (sold under conditions of monopoly power) relative to the prices of undifferentiated final products (sold under competitive conditions).

Nominal prices of intermediate goods (or less competitive goods more generally) are more rigid than prices of final (competitive) goods. As a result, unexpected inflation reduces the relative price of less competitive inputs and, thereby, mimics the productivity gains from an increase in competition.
In an open economy, unexpected inflation abroad also leads to productivity gains: domestic output is stimulated by the reductions in the relative price of foreign intermediates. Because of the distortion from mark-up pricing, this expansion of output is efficient over a range of unexpected inflation rates.
The analysis has some surprising implications for how trade and monetary union affect a policy-maker''s incentive to inflate. If the country is relatively closed to international trade, then the monetary authority would value surprise inflation since it will tend to lead to higher productivity.

Moreover, the higher the distortion, the greater is the incentive to inflate. Therefore, the inflation rate would tend to be higher the higher the level of monopoly power.

If the country opens up to trade, the incentive to inflate diminishes because part of the benefit from inflation surprises goes to residents of other countries. This effect is more important the lower are the trading costs, and the higher is the size of the trading partners.

Therefore, the inflation rate would tend to be lower in open economies. If the country decides to join a monetary union and the common monetary authority takes into account the beneficial effects of surprise inflation in all countries, then the equilibrium inflation rate tends to be higher than that without the monetary union.

The analysis implies that relative output prices are more counter-cyclical the less competitive the sector. To test this hypothesis, the researchers examine the behaviour of price deflators for industry shipments in US manufacturing at the four-digit level.

The data, which have been assembled by the National Bureau of Economic Research, are annual from 1958 to 1997 and cover over 400 industries. They reveal that relative output prices were indeed more counter-cyclical in the more concentrated manufacturing sectors.

''Closed and Open Economy Models of Business Cycles with Marked up and Sticky Prices'' by Robert Barro and Silvana Tenreyro is published in the April 2006 issue of the Economic Journal.